Petrodollar Wars 103: the Collapse of Bretton Woods – where I listed the various ways to arbitrage gold, how the gold standard forced America into the Triffin Dilemma, and how Mr Nixon suddenly and unilaterally told the French (and everyone else) to sod off.

In this post, we’re going to talk about what it means to be a global currency of reserve, and whether it’s really worth all the hassle.

What Is A Global Reserve Currency?

Officially speaking, a global reserve currency is what governments choose to store their foreign exchange reserves in – which is a wordy way of saying “this is the currency in which we will trade”.

For example, let’s say that a Liberian company wants to import diamonds from Sierra Leone. Unfortunately, the Liberians only have the Liberian dollar to pay with. And the Sierra Leoneans would probably like to get paid in Sierra Leonean leone, because that’s what they use to pay the diamond miners.

So a lack of exchangeable money would leave things at a bit of a standstill.

If that were actually the status quo, someone would eventually stand up and say:

what would be really helpful is some kind of global currency that the world could use for international trade.

And, like, a government could keep some of it in reserve

So that when their people want it to trade,

then they could bring their Liberian dollars and exchange them for the international currency,

take that and give it to their trading partner across the border,

who could then take it to their own government and change it for Sierra Leonean leones.

So as it turns out, every country that engages in trade (ie. every country) needs to keep a supply of foreign reserves. And those foreign reserves are going to be denominated in the global reserve currency.

But Who Decides Which Currency Gets To Be The Reserve Currency?

It’s a good question – and the answer, generally, is the same as the answer to the “what is money anyway” section of Petrodollar Wars 104: whichever currency is the most trusted and most widely used gets chosen by the “market”.

For example, when the British Empire was around, every second country to be traded with was a British Colony. Meaning that the Pound Sterling was usable the world over, which in turn meant that every country had a stock of pounds on hand. So even if you weren’t trading with a British colony – you could be pretty sure that the government of your trading partner would be happy to swap their local currency for British pounds so that you could pay your supplier. After all – those governments would always need British pounds to trade with.

So if a country wants to its currency to be a global reserve currency, then there are three things that it needs:

There needs to be a high global demand for the country’s exports (because these need to be paid for in the home currency, this means a corresponding high demand for the country’s currency);

There must be somewhere to store the currency while the trading partners are waiting to spend it (they must be able to invest it somewhere – which strongly implies that the country must have large developed financial markets); and

The trading partners must be able to get their hands on the currency in the first place.

America was dishing out dollars everywhere, and was also happy to exchange gold for dollars (requirement 3 – tick).

So it made the US dollar an obvious choice for a global reserve currency. Besides, all the Allies agreed that it would be so.

But Why Would a Country even want their currency to be a Global Currency of Reserve?

This is a surprisingly debated question, in the sense that there are some quite obvious advantages to being a Global Reserve Currency. But I guess it’s not that surprising when you look at those three requirements and realise that some things have changed since 1944…

In pure economic terms, here are the advantages for America:

Seigniorage Revenue: seigniorage revenue is the return offered to the Federal Reserve by inflation. Money is an effective “IOU” note printed by the Federal Reserve for us to use in circulation. If this were an IOU note between friends, maybe we’d say “I’m taking $100, so here’s an IOU note for $102 which I’ll give back next week” – meaning that there’d be an interest component. But in this case, the Fed “borrows” $100 from you by issuing you an IOU note, and “pays back” $100 when it retrieves it – making that bank note an interest free loan. And then inflation takes place – so $100 today will buy you more than $100 in a year’s time. And it’s that difference that gets recorded by the Fed as seigniorage revenue.

Low borrowing costs: because countries will need somewhere to invest their foreign exchange reserves (US dollars), they’re probably going to put it into the America’s bond markets – meaning that the American Government can borrow really cheaply. It’s part of the reason why America’s debt is so high – they’ve used the cheap borrowing component to fund their Social Welfare programs.

But no advantage comes without cost:

A strong/overvalued currency: because there is constant demand for dollars for international trade, and because countries are ploughing their reserves into American bond markets, it means that the dollar is going to be stronger than it should be otherwise. This negatively impacts American exporting firms, as well as American firms that compete with imported products (so almost everyone really). On the other hand, American consumers benefit from cheap imported products.

And that’s generally where the debate stops, or concludes, as though we’re saying:

“Well there we are then. Being a global reserve currency isn’t really that great or that bad – it’s only a small benefit – and China will never accept those costs so the dollar will reign forever.”

Rubbish.

The geo-political advantage of being the global currency of reserve is the real benefit. And once the inertia sets in – it’s very difficult to displace. Today, the dollar denominates world trade, and therefore the bulk of each country’s exchange reserves, as well as the largest part of the world’s derivative markets in swaps and international financing. There is global vested interest in the US dollar maintaining its hegemony.

Which means that the American government can almost borrow unpunished to fund its internal policies. Of course – America may be approaching that limit (because there must be a limit) – but look at how far they’ve come!

But more than this, it means that the United States wields dramatic economic power on the world stage (just look at what Obama has done to Iran). It brings security and access to resources and the ability to dictate from a distance. How do you put an economic price on that?

And the truth is that the decisions around the US dollar status are not made by economists or any of the McKinsey consultants that prepare these economic assessments. The decisions are made by politicians. Politicians who will make ridiculous economic choices if it appeals to their voting base.

Which brings me rather neatly back round to the politics of 1971, when Nixon had just suspended the Gold Standard to rapturous voter applause.